The “Show Me” State, or What Lies on This Side of “Fully Discounted”

Going into the Fed’s QE3 announcement on September 13, I heard surveys citing anywhere from 72-92% of respondents expecting the program’s initiation. Further, the market implied ~$850B worth of intervention. By the time the announcement confirmed those suspicions, a rally ensued that effectively discounted the present value of actual QE, making up for the balance of expectations that hadn’t forseen the measures. Hence, when the S&P 500 (SPX) hit a recent high closing price of 1465.77 on September 14, QE3 had been priced in. Markets have pulled-back since, and sentiment has migrated from “fully discounted” to “show me.”

Currently, we’re in the “show me” state (not to be confused with Missouri). This is a state in which the market seems fully valued, waiting for more information to push or pull it one way or another. It’s an anxious state of which I warned:

“[M]arket participants eventually come to anticipate interventions after central banks have to repeatedly defend stated floors or ceilings. Hence, investors frontrun every subsequent intervention, their preemption occurring earlier and earlier until the actual intervention itself has no effect. Then, the central bank is considered impotent in affecting its target market, and the whole charade unravels. This feedback loop is a credibility trap.”

We’ve been through these QE things before here in the US– two times before, to be exact. As a how-not-to guide, Japan has beat the QE drum 8 times in modern history. Given these historical precedents, we’re now able to model the effect and follow analogues, eliminating variables and controlling for inputs that may differ between one instance and another.

Now, today, it’s not about what happened last month or last quarter. While the market may react negatively to some headline risk, earnings reports and macro data mean nothing. Those things are lagging indicators; they happened in the past. It’s all about the future, what’s coming. It’s all about what QE does to affect capital flows, confidence, and consumers (in that order). So far, we’ve received a profit warnings from FedEx (FDX) and Norfolk Southern (NSC), who warn of macro risks to global growth. That’s a tough start to QE. That signals a chink in confidence’s armor.

Railroad traffic came in weak today too, in my opinion. Rail traffic continued to show an expansion, but the skinny growth rate started decelerating for the first time in a while. I’m watching business inventories to look for a flow-through of weakness from upstream to downstream. A favorite indicator of mine (along with PMIs & rail traffic), business inventories incorporate lagging activity that’s influenced by future expectations of consumer spending patterns. Hence, inventories provide a valuable appraisal of both confidence & consumers. With inventories falling from highs that have proven to be a ceiling throughout history, I’m interested to see if QE can kindle confidence such that inventories reverse higher.

We’ve fully discounted QE3, now show me why I should buy at 4-year highs.